APPLIED  CORPORATE  FINANCE:  A  BIG  PICTURE  VIEW  Aswath  Damodaran  www.damodaran.com  

2

What  is  corporate  finance?  

¨  Every  decision  that  a  business  makes  has  financial  implicaKons,  and  any  decision  which  affects  the  finances  of  a  business  is  a  corporate  finance  decision.    

¨  Defined  broadly,  everything  that  a  business  does  fits  under  the  rubric  of  corporate  finance.  

3

First  Principles  

4

The  ObjecKve  in  Decision  Making  

Aswath Damodaran

4

¨  In  tradiKonal  corporate  finance,  the  objecKve  in  decision  making  is  to  maximize  the  value  of  the  firm.    

¨  A  narrower  objecKve  is  to  maximize  stockholder  wealth.  When  the  stock  is  traded  and  markets  are  viewed  to  be  efficient,  the  objecKve  is  to  maximize  the  stock  price.  

Assets Liabilities

Assets in Place Debt

Equity

Fixed Claim on cash flowsLittle or No role in managementFixed MaturityTax Deductible

Residual Claim on cash flowsSignificant Role in managementPerpetual Lives

Growth Assets

Existing InvestmentsGenerate cashflows todayIncludes long lived (fixed) and

short-lived(working capital) assets

Expected Value that will be created by future investments

Maximize firm value

Maximize equity value

Maximize market estimate of equity value

5

The  Classical  ObjecKve  FuncKon  

STOCKHOLDERS

Maximizestockholder wealth

Hire & firemanagers- Board- Annual Meeting

BONDHOLDERSLend Money

ProtectbondholderInterests

FINANCIAL MARKETS

SOCIETYManagers

Revealinformationhonestly andon time

Markets areefficient andassess effect onvalue

No Social Costs

Costs can betraced to firm

6

What  can  go  wrong?  

STOCKHOLDERS

Managers puttheir interestsabove stockholders

Have little controlover managers

BONDHOLDERSLend Money

Bondholders canget ripped off

FINANCIAL MARKETS

SOCIETYManagers

Delay badnews or provide misleadinginformation

Markets makemistakes andcan over react

Significant Social Costs

Some costs cannot betraced to firm

7

Who  is  on  Board?  CRH’s  board  assessment  

Does CRH have an independent board?a.  Yesb.  No

Does CRH have an effective board?a.  Yesb.  No

8

When  tradiKonal  corporate  financial  theory  breaks  down,  the  soluKon  is:  

Aswath Damodaran

8

¨  To  choose  a  different  mechanism  for  corporate  governance,  i.e,  assign  the  responsibility  for  monitoring  managers  to  someone  other  than  stockholders.  

¨  To  choose  a  different  objecKve  for  the  firm.  ¨  To  maximize  stock  price,  but  reduce  the  potenKal  for  conflict  and  breakdown:  ¤  Making  managers  (decision  makers)  and  employees  into  stockholders  

¤  Protect  lenders  from  expropriaKon  ¤  By  providing  informaKon  honestly  and  promptly  to  financial  markets  

¤  Minimize  social  costs    

9

A  Market  Based  SoluKon  

STOCKHOLDERS

Managers of poorly run firms are puton notice.

1. More activistinvestors2. Hostile takeovers

BONDHOLDERSProtect themselves

1. Covenants2. New Types

FINANCIAL MARKETS

SOCIETYManagers

Firms arepunishedfor misleadingmarkets

Investors andanalysts becomemore skeptical

Corporate Good Citizen Constraints

1. More laws2. Investor/Customer Backlash

10

ApplicaKon  Test:  Who  owns/runs  your  firm?  

¨  Who  are  the  top  stockholders  in  your  firm?  ¨  What  are  the  potenKal  conflicts  of  interests  that  you  see  emerging  from  

this  stockholding  structure?  

Control of the firm

Outside stockholders- Size of holding- Active or Passive?- Short or Long term?

Inside stockholders% of stock heldVoting and non-voting sharesControl structure

Managers- Length of tenure- Links to insiders

Government

Employees Lenders

11

Who  owns  your  equity?  CRH’s  top  stockholders  in  2015  

12

And  the  geographical  breakdown..  

13

First  Principles  

14

What  is  Risk?  

¨  Risk,  in  tradiKonal  terms,  is  viewed  as  a  ‘negaKve’.  Webster’s  dicKonary,  for  instance,  defines  risk  as  “exposing  to  danger  or  hazard”.  The  Chinese  symbols  for  risk,  reproduced  below,  give  a  much  beaer  descripKon  of  risk:  

¨  The  first  symbol  is  the  symbol  for  “danger”,  while  the  second  is  the  symbol  for  “opportunity”,  making  risk  a  mix  of  danger  and  opportunity.  You  cannot  have  one,  without  the  other.  

15

AlternaKves  to  the  CAPM  

The risk in an investment can be measured by the variance in actual returns around an expected return

E(R)

Riskless Investment Low Risk Investment High Risk Investment

E(R) E(R)

Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk)Can be diversified away in a diversified portfolio Cannot be diversified away since most assets1. each investment is a small proportion of portfolio are affected by it.2. risk averages out across investments in portfolioThe marginal investor is assumed to hold a “diversified” portfolio. Thus, only market risk will be rewarded and priced.

The CAPM The APM Multi-Factor Models Proxy ModelsIf there is 1. no private information2. no transactions costthe optimal diversified portfolio includes everytraded asset. Everyonewill hold this market portfolioMarket Risk = Risk added by any investment to the market portfolio:

If there are no arbitrage opportunities then the market risk ofany asset must be captured by betas relative to factors that affect all investments.Market Risk = Risk exposures of any asset to market factors

Beta of asset relative toMarket portfolio (froma regression)

Betas of asset relativeto unspecified marketfactors (from a factoranalysis)

Since market risk affectsmost or all investments,it must come from macro economic factors.Market Risk = Risk exposures of any asset to macro economic factors.

Betas of assets relativeto specified macroeconomic factors (froma regression)

In an efficient market,differences in returnsacross long periods mustbe due to market riskdifferences. Looking forvariables correlated withreturns should then give us proxies for this risk.Market Risk = Captured by the Proxy Variable(s)

Equation relating returns to proxy variables (from aregression)

Step 1: Defining Risk

Step 2: Differentiating between Rewarded and Unrewarded Risk

Step 3: Measuring Market Risk

16

Inputs  required  to  use  the  CAPM  -­‐    

¨  The  capital  asset  pricing  model  yields  the  following  expected  return:  ¤  Expected  Return  =  Riskfree  Rate+  Beta  *  (Expected  Return  on  the  Market  Porgolio  -­‐  Riskfree  Rate)  

¨  To  use  the  model  we  need  three  inputs:  a.  The  current  risk-­‐free  rate  b.  The  expected  market  risk  premium  (the  premium  

expected  for  invesKng  in  risky  assets  (market  porgolio)  over  the  riskless  asset)    

c.  The  beta  of  the  asset  being  analyzed.    

17

I.  A  Riskfree  Rate  

¨  On  a  riskfree  asset,  the  actual  return  is  equal  to  the  expected  return.  Therefore,  there  is  no  variance  around  the  expected  return.  

¨  For  an  investment  to  be  riskfree,  then,  it  has  to  have  ¤  No  default  risk  ¤  No  reinvestment  risk  

1.  Time  horizon  maaers:  Thus,  the  riskfree  rates  in  valuaKon  will  depend  upon  when  the  cash  flow  is  expected  to  occur  and  will  vary  across  Kme.    

2.  Not  all  government  securiKes  are  riskfree:  Some  governments  face  default  risk  and  the  rates  on  bonds  issued  by  them  will  not  be  riskfree.  

Aswath Damodaran

17

18

Risk  free  rates  by  currency:  January  2015  

-­‐2.00%  

0.00%  

2.00%  

4.00%  

6.00%  

8.00%  

10.00%  

12.00%  

14.00%  

16.00%  

Japane

se  Yen

 Czech  Ko

runa  

Swiss  Franc  

Euro  

Danish  Krone

 Sw

edish

 Krona  

Taiwanese  $  

Hungarian  Forin

t  Bu

lgarian  Lev  

Kuna  

Thai  Baht  

BriKsh  Pou

nd  

Romanian  Leu  

Norwegian  Kron

e  HK

 $  

Israeli  She

kel  

Polish  Zloty  

Canadian  $  

Korean  W

on  

US  $  

Singapore  $  

Phillipine  Pe

so  

Pakistani  Rup

ee  

Vene

zuelan  Bolivar  

Vietnamese  Do

ng  

Australian  $  

Malyasia

n  Ringgit  

Chinese  Yuan  

NZ  $  

Chilean  Peso  

Iceland  Kron

a  Pe

ruvian  Sol  

Mexican  Peso  

Colombian  Peso  

Indo

nesia

n  Ru

piah  

Indian  Rup

ee  

Turkish

 Lira

 South  African  Rand  

Kenyan  Shilling  

Reai  

Naira  

Russian  Ru

ble  

Riskfree  Rates:  January  2015  

Risk  free  Rate   Default  Spread  based  on  raKng  

19

The  Euro  Risk  Free  Rate:  March  2015  

0.00%  

2.00%  

4.00%  

6.00%  

8.00%  

10.00%  

12.00%  

0.21%   0.29%   0.36%   0.36%   0.46%   0.48%   0.80%  1.27%   1.30%  

1.78%  

11.33%  

Ten-­‐year  Government  Bonds  in  Euros  

20

II.  The  Equity  Risk  Premium  

       Historical premium for the US

  Arithmetic Average Geometric Average  Stocks - T. Bills Stocks - T. Bonds Stocks - T. Bills Stocks - T. Bonds1928-2014 8.00% 6.25% 6.11% 4.60%  2.17% 2.32%    1965-2014 6.19% 4.12% 4.84% 3.14%  2.42% 2.74%    2005-2014 7.94% 4.06% 6.18% 2.73%  6.05% 8.65%    

Base year cash flow (last 12 mths)Dividends (TTM): 38.57+ Buybacks (TTM): 61.92

= Cash to investors (TTM): 100.50Earnings in TTM: 114.74

Expected growth in next 5 yearsTop down analyst estimate of earnings

growth for S&P 500 with stable payout: 5.58%

106.10 112.01 118.26 124.85 131.81 Beyond year 5Expected growth rate = Riskfree rate = 2.17%

Expected CF in year 6 = 131.81(1.0217)

Risk free rate = T.Bond rate on 1/1/15= 2.17%

r = Implied Expected Return on Stocks = 7.95%

S&P 500 on 1/1/15= 2058.90

E(Cash to investors)

Minus

Implied Equity Risk Premium (1/1/15) = 7.95% - 2.17% = 5.78%

Equals

100.5 growing @ 5.58% a year

2058.90 = 106.10(1+ r)

+112.91(1+ r)2

+118.26(1+ r)3

+124.85(1+ r)4

+131.81(1+ r)5

+131.81(1.0217)(r −.0217)(1+ r)5

21

Country  Risk:  Look  at  a  country’s  bond  raKng  and  default  spreads  as  a  start  

¨  In  this  approach,  the  country  equity  risk  premium  is  set  equal  to  the  default  spread  for  the  country,  esKmated  in  one  of  three  ways:  ¤  The  default  spread  on  a  dollar  denominated  bond  issued  by  the  country.  

(In  January  2015,  that  spread  was  1.55%  for  the  Brazilian  $  bond)  ¤  The  sovereign  CDS  spread  for  the  country.  In  January  2015,  the  ten  year  

CDS  spread  for  Brazil  was  2.86%.  ¤  The  default  spread  based  on  the  local  currency  raKng  for  the  country.  

Brazil’s  sovereign  local  currency  raKng  is  Baa2  and  the  default  spread  for  a  Baa2  rated  sovereign  was  about  1.90%  in  January  2015.    

¨  Many  analysts  add  this  default  spread  to  the  US  risk  premium  to  come  up  with  a  risk  premium  for  a  country.  This  would  yield  a  risk  premium  of  7.65%  for  Brazil,  if  we  use  5.75%  as  the  US  risk  premium  and  the  default  spread  based  on  the  raKng.  

22

Beyond  the  default  spread  

¨  Country  raKngs  measure  default  risk.  While  default  risk  premiums  and  equity  risk  premiums  are  highly  correlated,  one  would  expect  equity  spreads  to  be  higher  than  debt  spreads.    

¨  Another  is  to  mulKply  the  bond  default  spread  by  the  relaKve  volaKlity  of  stock  and  bond  prices  in  that  market.    Using  this  approach  for  Brazil  in  January  2015,  you  would  get:  ¤  Country  Equity  risk  premium  =  Default  spread  on  country  bond*  σCountry  

Equity  /  σCountry  Bond  n  Standard  DeviaKon  in  Bovespa  (Equity)  =  21%  n  Standard  DeviaKon  in  Brazil  government  bond  =  14%  n  Default  spread  on  C-­‐Bond  =  1.90%  

¤  Brazil  Country  Risk  Premium  =  1.90%  (21%/14%)  =    2.85%  ¤  Brazil  Total  ERP  =  Mature  Market  Premium  +  CRP  =  5.75%  +  2.85%  =  8.60%  

Black #: Total ERPRed #: Country risk premiumAVG: GDP weighted average

ERP

: Jan

201

5

Angola   10.25%   4.50%  Botswana   7.03%   1.28%  Burkina  Faso   15.50%   9.75%  Cameroon   14.00%   8.25%  Cape  Verde   14.00%   8.25%  Congo  (DR)   15.50%   9.75%  Congo  (Republic)   11.15%   5.40%  Côte  d'Ivoire   12.50%   6.75%  Egypt   17.00%   11.25%  Ethiopia   12.50%   6.75%  Gabon   11.15%   5.40%  Ghana   14.00%   8.25%  Kenya   12.50%   6.75%  Morocco   9.50%   3.75%  Mozambique   12.50%   6.75%  Namibia   9.05%   3.30%  Nigeria   11.15%   5.40%  Rwanda   14.00%   8.25%  Senegal   12.50%   6.75%  South  Africa   8.60%   2.85%  Tunisia   11.15%   5.40%  Uganda   12.50%   6.75%  Zambia   12.50%   6.75%  Africa   11.73%   5.98%  

Bangladesh   11.15%   5.40%  Cambodia   14.00%   8.25%  China   6.65%   0.90%  Fiji   12.50%   6.75%  Hong  Kong   6.35%   0.60%  India   9.05%   3.30%  Indonesia   9.05%   3.30%  Japan   6.80%   1.05%  Korea   6.65%   0.90%  Macao   6.50%   0.75%  Malaysia   7.55%   1.80%  MauriKus   8.15%   2.40%  Mongolia   14.00%   8.25%  Pakistan   17.00%   11.25%  Papua  New  Guinea   12.50%   6.75%  Philippines   8.60%   2.85%  Singapore   5.75%   0.00%  Sri  Lanka   12.50%   6.75%  Taiwan   6.65%   0.90%  Thailand   8.15%   2.40%  Vietnam   12.50%   6.75%  Asia   7.26%   1.51%  

Australia   5.75%   0.00%  Cook  Islands   12.50%   6.75%  New  Zealand   5.75%   0.00%  Australia  &  NZ   5.75%   0.00%  

Abu  Dhabi   6.50%   0.75%  Bahrain   8.60%   2.85%  Israel   6.80%   1.05%  Jordan   12.50%   6.75%  Kuwait   6.50%   0.75%  Lebanon   14.00%   8.25%  Oman   6.80%   1.05%  Qatar   6.50%   0.75%  Ras  Al  Khaimah   7.03%   1.28%  Saudi  Arabia   6.65%   0.90%  Sharjah   7.55%   1.80%  UAE   6.50%   0.75%  Middle  East   6.85%   1.10%  

Albania   12.50%   6.75%   Montenegro   11.15%   5.40%  Armenia   10.25%   4.50%   Poland   7.03%   1.28%  Azerbaijan   9.05%   3.30%   Romania   9.05%   3.30%  Belarus   15.50%   9.75%   Russia   8.60%   2.85%  Bosnia   15.50%   .75%   Serbia   12.50%   6.75%  Bulgaria   8.60%   2.85%   Slovakia   7.03%   1.28%  CroaKa   9.50%   3.75%   Slovenia   9.50%   3.75%  Czech  Repub   6.80%   1.05%   Ukraine   20.75%   15.00%  Estonia   6.80%   1.05%   E.  Europe   9.08%   3.33%  Georgia   11.15%   5.40%  Hungary   9.50%   3.75%  Kazakhstan   8.60%   2.85%  Latvia   8.15%   2.40%  Lithuania   8.15%   2.40%  Macedonia   11.15%   5.40%  Moldova   15.50%   9.75%  

Andorra   8.15%   2.40%   Italy   8.60%   2.85%  Austria   5.75%   0.00%   Jersey   6.35%   0.60%  Belgium   6.65%   0.90%   Liechtenstein   5.75%   0.00%  Cyprus   15.50%   9.75%   Luxembourg   5.75%   0.00%  Denmark   5.75%   0.00%   Malta   7.55%   1.80%  Finland   5.75%   0.00%   Netherlands   5.75%   0.00%  France   6.35%   0.60%   Norway   5.75%   0.00%  Germany   5.75%   0.00%   Portugal   9.50%   3.75%  Greece   17.00%   11.25%   Spain   8.60%   2.85%  Guernsey   6.35%   0.60%   Sweden   5.75%   0.00%  Iceland   9.05%   3.30%   Switzerland   5.75%   0.00%  Ireland   8.15%   2.40%   Turkey   9.05%   3.30%  Isle  of  Man   6.35%   0.60%   UK   6.35%   0.60%  

W.  Europe   6.88%   1.13%  

ArgenKna   17.00%   11.25%  Belize   19.25%   13.50%  Bolivia   11.15%   5.40%  Brazil   8.60%   2.85%  Chile   6.65%   0.90%  Colombia   8.60%   2.85%  Costa  Rica   9.50%   3.75%  Ecuador   15.50%   9.75%  El  Salvador   11.15%   5.40%  Guatemala   9.50%   3.75%  Honduras   15.50%   9.75%  Mexico   7.55%   1.80%  Nicaragua   15.50%   9.75%  Panama   8.60%   2.85%  Paraguay   10.25%   4.50%  Peru   7.55%   1.80%  Suriname   11.15%   5.40%  Uruguay   8.60%   2.85%  Venezuela   17.00%   11.25%  LaHn  America   9.95%   4.20%  

Canada   5.75%   0.00%  US   5.75%   0.00%  North  America   5.75%   0.00%  

24

CRH:  Equity  Risk  Premium  

Implication 1: A CRH investment in North America, in any given business or currency, will require a lower cost of equity than an equivalent investment in Western Europe.Implication 2: Given the divergence of ERP within Europe, an investment in Ireland or Poland will require a higher cost of equity than an equivalent investment in the Netherlands.

Region  Sales  (in  millions  of  

Euros)   Propor=on  Weighted  average  ERP  

for  region   Weight  *  ERP  North  America   10071   53.17%   5.75%   3.06%  

Europe   8871   46.83%   6.88%   3.22%  CRH   18942   100.00%       6.28%  

25

Just  be  glad  that  you  are  not  Coca  Cola  (from  2012)  

Things to watch out for1.  Aggregation across regions. For instance, the Pacific region often includes Australia & NZ with Asia2.  Obscure aggregations including Eurasia and Oceania

26

EsKmaKng  Beta:  The  Regression  Approach  

27

And  another  regression…  

28

Determinants  of  Betas  

29

Boaom  up  beta  for  CRH  

CRH  is  in  3  businesses,  and  we  esKmate  the  beta  of  each  one:    

¨  Step  1:  Start  with  CRH’s  revenues  by  business.  ¨  Step  2:  EsKmate  the  value  as  a  mulKple  of  revenues  by  looking  

at  what  the  market  value  of  publicly  traded  firms  in  each  business  is,  relaKve  to  revenues.        EV/Sales  =    

¨  Step  3:  MulKply  the  revenues  in  step  1  by  the  industry  average  mulKple  in  step  2  to  get  the  esKmated  value,  by  business.  €

Mkt Equity +Debt - CashRevenues

CRH  Division   Business   Revenues   EV/Sales  Es=mated  Value   Propor=on  

Unlevered  Beta  

Heavyside/Materials   ConstrucKon  Supplies   8,999.00€   1.3707    12,335  €     49.21%   0.8934  Lightside/Products   Building  Materials   4,138.00€   1.1117    4,600  €     18.35%   0.7998  DistribuKon   Retail  (Building  Supply)   5,775.00€   1.4076    8,129  €     32.43%   0.8970  CRH:  Company       18,912.00€        25,063  €         0.8774  

30

CRH’s  Cost  of  Equity  

¨  Step  1:  Allocate  debt  across  businesses  

¨  Step  2:  Compute  levered  betas  and  costs  of  equity  for  CRH’s  operaKng  businesses.  

CRH  Division   Es=mated  Value  

Sector-­‐average  D/E  

ra=o  Es=mated  Value  

Debt  based  on  Sector  average  

Propor=on  of  debt  in  division  

Actual  Debt  allocated  

CRH  Divisional  D/E  ra=o  

Heavyside/Materials   ConstrucKon  Supplies   47.79%   12,334.55€    3,989  €     57.83%   3,601€   47.79%  Lightside/Products   Building  Materials   37.23%   4,600.25€    1,248  €     18.09%   1,127€   37.23%  DistribuKon   Retail  (Building  Supply)   25.68%   8,128.64€    1,661  €     24.08%   1,500€   25.68%  CRH:  Company                6,897  €          6,228  €     30.27%  

CRH  Division   Unlevered  Beta  CRH  Divisional  

D/E  ra=o   Levered  Beta  Cost  of  Equity  

Cost  of  Equity  Europe  (Euros)  

Cost  of  Equity  North  America  (Euros)  

Cost  of  Equity  North  America  (US  $)  

Heavyside/Materials   0.8934   47.79%   1.1923   7.70%   8.41%   7.07%   8.86%  Lightside/Products   0.7998   37.23%   1.0082   6.54%   7.15%   6.01%   7.80%  

DistribuKon   0.8970   25.68%   1.0582   6.86%   7.49%   6.29%   8.08%  CRH:  Company   0.8774   30.27%   1.0633   6.89%   7.53%   6.32%   8.11%  

31

 Discussion  Issue  

¨  The  head  of  the  European  distribuHon  business  has  come  to  you  with  a  new  investment  in  Poland  that  he  would  like  you  to  fund.  He  claims  that  his  analysis  of  the  movie  indicates  that  it  will  generate  a  return  on  equity  of  10%  (in  Zlotys).  Would  you  fund  it?  a.  Yes.    b.  No.    What  return  on  equity  would  this  investment  need  to  make  to  be  jusKfied?  Why?  (The  inflaKon  rate  in  Zlotys  is  2%  whereas  the  inflaKon  rate  in  Euros  is  close  to  zero).  

32

EsKmaKng  the  Cost  of  Debt  

¨  If  the  firm  has  bonds  outstanding,  and  the  bonds  are  traded,  the  yield  to  maturity  on  a  long-­‐term,  straight  (no  special  features)  bond  can  be  used  as  the  interest  rate.  

¨  If  the  firm  is  rated,  use  the  raKng  and  a  typical  default  spread  on  bonds  with  that  raKng  to  esKmate  the  cost  of  debt.  

¨  If  the  firm  is  not  rated,    ¤  and  it  has  recently  borrowed  long  term  from  a  bank,  use  the  interest  

rate  on  the  borrowing  or  ¤  esKmate  a  syntheKc  raKng  for  the  company,  and  use  the  syntheKc  

raKng  to  arrive  at  a  default  spread  and  a  cost  of  debt  

¨  The  cost  of  debt  has  to  be  esKmated  in  the  same  currency  as  the  cost  of  equity  and  the  cash  flows  in  the  valuaKon.  

33

EsKmaKng  SyntheKc  RaKngs  

¨  The  raKng  for  a  firm  can  be  esKmated  using  the  financial  characterisKcs  of  the  firm.  In  its  simplest  form,  we  can  use  just  the  interest  coverage  raKo:  

¨  Interest  Coverage  RaKo  =  EBIT  /  Interest  Expenses  ¨  For  CRH,  we  obtain  the  following:  

¤  OperaKng  Income/  Interest  Expense  =  966/258  =  3.74  ¤  For  every  euro  in  interest  expenses,  CRH  delivers  3.74  Euros  in  

operaKng  income.  

34

Interest  Coverage  RaKos,  RaKngs  and  Default  Spreads  

Interest coverage ratio Rating is Spread is> 8.5 Aaa/AAA   0.40%

6.5-8.5 Aa2/AA   0.70%5.5-6.5 A1/A+   0.90%4.25-5.5 A2/A   1.00%3-4.25 A3/A-­‐   1.20%2.5-3 Baa2/BBB   1.75%

2.25-2.5 Ba1/BB+   2.75%2-2.25 Ba2/BB   3.25%1.75-2 B1/B+   4.00%

1.5-1.75 B2/B   5.00%1.25-1.5 B3/B-­‐   6.00%0.8-1.25 C2/C   7.00%0.65-0.85 Ca2/CC   8.00%0.2-0.65 Caa/CCC   10.00%

<0.25 D2/D   12.00%

CRH, Market Cap > $ 5 billion: 3.74 à Synthetic rating = A3/A-

CRH’s actual rating is Baa2/BBB+.

35

CRH’s  cost  of  debt  

¨  Based  on  the  actual  raKng,  the  default  spread  is  1.75%,  which  can  be  added  to  the  risk  free  rate  of  0.21%  to  arrive  at  a  pre-­‐tax  cost  of  debt  of  1.96%  (in  Euros).  

¨  Given  that  CRH  derives  so  much  of  its  revenues  outside  Ireland,  it  makes  sense  for  it  to  place  most  of  its  debt  in  the  US  and  claim  a  tax  benefit,  based  upon  the  US  marginal  tax  rate  of  30%.  ¤  Axer-­‐tax  cost  of  debt  =  1.96%  (1-­‐.30)  =    1.37%  

¨  If  you  were  compuKng  the  cost  of  debt  in  US  dollar  terms,  you  would  start  with  the  US  $  risk  free  rate  instead:  ¤  Pre-­‐tax  cost  of  debt  =  2.00%  +  1.75%  =  3.75%  ¤  Axer-­‐tax  cost  of  debt  =  3.75%  (1-­‐.30)  =  2.625%  

36

Current  Cost  of  Capital:  CRH  

All  in  Euros  

CRH  Division  CRH  Divisional    D/E  ra=o  

Divisional  Debt  to  Capital  Ra=o  

Cost  of  equity  

ANer-­‐tax  cost  of  debt  

Cost  of  capital  

Cost  of  Capital  Europe  (Euros)  

Cost  of  Capital  North  America  (Euros)  

Cost  of  Capital  North  America  (US  $)  

Heavyside/Materials   47.79%   32.34%   7.70%   1.37%   5.65%   6.14%   5.22%   6.84%  Lightside/Products   37.23%   27.13%   6.54%   1.37%   5.14%   5.58%   4.75%   6.39%  

DistribuKon   25.68%   20.43%   6.86%   1.37%   5.73%   6.24%   5.29%   6.97%  CRH:  Company   30.27%   23.24%   6.89%   1.37%   5.61%   6.10%   5.17%   6.84%  

37

Back  to  First  Principles  

38

Measuring  Returns  Right:  The  Basic  Principles  

¨  Use  cash  flows  rather  than  earnings.  You  cannot  spend  earnings.  

¨  Use  “incremental”  cash  flows  relaKng  to  the  investment  decision,  i.e.,  cashflows  that  occur  as  a  consequence  of  the  decision,  rather  than  total  cash  flows.  

¨  Use  “Kme  weighted”  returns,  i.e.,  value  cash  flows  that  occur  earlier  more  than  cash  flows  that  occur  later.  The  Return  Mantra:  “Time-­‐weighted,  Incremental  Cash  

Flow  Return”  

39

The  CRH  Asset  Purchase  

¨  LaFarge  and  Holcim,  as  part  of  a  requirement  to  complete  a  merger,  were  forced  to  sell  some  of  their  assets  and  CRH  was  a  potenKal  buyer.  

¨  The  assets  had  a  price  tag  of  6.5  billion  Euros  and  offered  CRH  a  chance  to  enter  “new”  markets  and  perhaps  other  synergies.  

¨  CRH  planned  to  finance  this  merger  with  the  following  combinaKon:  ¤  1.6  billion  Euros  from  a  new  equity  offering  ¤  2.0  billion  Euros  in  cash  ¤  2.9  billion  Euros  of  new  debt  

40

What  are  you  buying?  

¨  Business:  The  assets  are  primarily  in  the  construcKon  material  (cement)  business.  

¨  Geographies:  The  revenues  from  these  assets  come  from  Britain,  Canada,  Brazil  and  parts  of  Asia  and  there  are  producKon  faciliKes  in  Asia  and  LaKn  America.  Buying  these  assets  will  double  CRH’s  exposure  to  emerging  markets.  

¨  OperaKons:  The  assets  generated  6  billion  Euros  in  revenues  in  the  most  recent  year.  

41

EsKmaKng  a  cost  of  capital  for  this  asset  acquisiKon  

¨  In  esKmaKng  a  ‘hurdle  rate’  to  use  in  assessing  this  acquisiKon,  what  should  you  use  as  ¤  The  risk  free  rate?  

¤  The  beta  for  the  investment  (risk)?  

¤  The  equity  risk  premium?  

¤  The  debt  mix?  

42

Cost  of  capital  for  asset  acquisiKon  

Risk free Rate = 0.21% Beta = 1.1923+ X = Cost of Equity = 8.79%

Risk free Rate = 0.21%

Default Spread = 1.75%

(1- Tax Rate of 30%) = Cost of debt = 1.37%

Debt to Capital = 32.34%

Equity to Capital = 67.66%

Cost of capital = 8.79% (.6766) + 1.37% (.3234) = 6.39%

Analysis done in Euros (choice)

Levered beta for construction supplies

ERP of regions where assets are located

Debt ratio of CRH construction supplies division

Default spread for CRH, based on Baa2 rating

Marginal tax rate for CRH

Regions Proportion ERPAsia 30% 7.26%Latin/America 20% 9.95%UK 25% 6.35%Canada 25% 5.75%

7.19300%

43

Expected  Earnings  on  acquired  assets:  AssumpKons  

¨  The  acquired  assets  are  primarily  in  the  construcKon  supplies  business.  ¨  The  assets  generated  6  billion  Euros  in  revenues  last  year  and  those  revenues  are  

expected  to  grow  8%  a  year  for  the  next  5  years,  5%  a  year  for  the  following  5  years  and  then  seale  into  mature  growth  (growth  rate  of  the  global  economy).  

¨  The  assets  currently  has  an  EBITDA/Sales  margin  of  10%  but  this  will  rise  over  the  next  5  years  to    12.27%,  the  average  for  construcKon  supplies  companies  in  2014.  The  DA/Sales  will  be  4.51%for  the  next  10  years  (resulKng  in  a  steady  state  operaKng  margin  of  7.76%);  this  was  the  average  for  global  construcKon  supplies  companies  in  2014.  

¨  To  maintain  the  earning  power  of  the  assets  and  to  generate  the  expected  growth,  CRH  will  have  to  reinvest  110%  of  its  depreciaKon  as  capital  expenditures  each  year.  

¨  The  non-­‐cash  working  capital  invested  will  amount  to  16.27%  of  revenues,  the  industry  average  for  construcKon  supplies  in  2014.  

¨  The  average  tax  rate  that  CRH  will  pay  on  its  earnings  from  these  assets  will  be  30%.  

44

Step  1:  EsKmate  AccounKng  Earnings  on  Project  

 Year   1   2   3   4   5   6   7   8   9   10  

Revenues   €  6,300   €  6,804   €  7,348   €  7,936   €  8,571   €  9,000   €  9,450   €  9,922   €  10,418   €  10,939  

EBITDA  Margin   10.45%   10.91%   11.36%   11.82%   12.27%   12.27%   12.27%   12.27%   12.27%   12.27%  

EBITDA     €  659   €  742   €  835   €  938   €  1,052   €  1,104   €  1,159   €  1,217   €  1,278   €  1,342  

DA   €  284   €  307   €  331   €  358   €  387   €  406   €  426   €  447   €  470   €  493  

EBIT   €  374   €  435   €  504   €  580   €  665   €  698   €  733   €  770   €  808   €  849  

Taxes   €  112   €  131   €  151   €  174   €  200   €  210   €  220   €  231   €  243   €  255  

EBIT  (1-­‐t)   €  262   €  305   €  352   €  406   €  466   €  489   €  513   €  539   €  566   €  594  

45

And  the  AccounKng  View  of  Return  

Invested Capital = Capital invested at start of the year + Capital Expenditures – Depreciation + Change in non-cash WC

Year   Afrer-­‐tax  OperaKng  Income   Invested  Capital   ROIC  

1   €  262.13   €  6,500.00   4.03%  

2   €  304.72   €  6,577.22   4.63%  

3   €  352.45   €  6,689.91   5.27%  

4   €  405.87   €  6,811.61   5.96%  

5   €  465.58   €  6,943.05   6.71%  

6   €  488.86   €  7,085.00   6.90%  

7   €  513.30   €  7,195.32   7.13%  

8   €  538.97   €  7,311.15   7.37%  

9   €  565.92   €  7,432.77   7.61%  

10   €  594.21   €  7,560.47   7.86%  

Average   6.35%  

46

A  tangent:  How  do  CRH’s  exisKng  investments  measure  up?  

CRH  Division   EBITDA  

Opera=ng  Income  (2014)  

Invested  Capital   ROIC  

Cost  of  Capital   Total  Assets  

%  of  invested  capital  

Heavyside  Europe   €  380   €  151   €  2,956   3.93%   6.14%   €  3,864   23.30%  Materials  US   €  609   €  355   €  4,777   5.71%   5.22%   €  6,245   37.66%  Lightside  Europe   €  94   €  71   €  582   9.37%   5.58%   €  761   4.59%  Products  US   €  263   €  145   €  1,945   5.73%   4.75%   €  2,542   15.33%  DistribuKon  Europe   €  190   €  112   €  1,699   5.07%   6.24%   €  2,221   13.39%  DistribuKon  US   €  105   €  83   €  727   8.77%   5.29%   €  951   5.73%  CRH:  Company   €  1,641   €  917   €  12,686   5.56%   5.61%   €  16,584  

47

The  cash  flow  view  of  this  project..  

    1   2   3   4   5   6   7   8   9   10  

EBIT  (1-­‐t)   €  262   €  305   €  352   €  406   €  466   €  489   €  513   €  539   €  566   €  594  

 +  DA   €  284   €  307   €  331   €  358   €  387   €  406   €  426   €  447   €  470   €  493  

 -­‐  Cap  Ex   €  313   €  338   €  365   €  394   €  425   €  446   €  469   €  492   €  517   €  543  

 -­‐  Chg  WC   €  49   €  82   €  89   €  96   €  103   €  70   €  73   €  77   €  81   €  85  

FCFF   €  185   €  192   €  231   €  274   €  324   €  379   €  397   €  417   €  438   €  460  

To get from income to cash flow, we● added back all non-cash charges such as depreciation. Tax benefits:

● subtracted out the capital expenditures● subtracted out the change in non-cash working capital

    1   2   3   4   5   6   7   8   9   10  DA   €  284   €  307   €  331   €  358   €  387   €  406   €  426   €  447   €  470   €  493  Tax  rate  *DA   €  85   €  92   €  99   €  107   €  116   €  122   €  128   €  134   €  141   €  148  

48

To  incremental  cash  flows  

¨  The  principle  of  “incremental”  cash  flows:  Here  is  a  simple  test:  ¤  What  will  happen  (to  this  line  item)  if  I  take  this  investment?  ¤  What  will  happen  (to  this  line  item)  if  I  do  not?  ¤  If  the  answer  is  the  same,  that  item  is  non-­‐incremental  and  should  not  

affect  this  decision.  ¨  Any  sunk  costs?  

¤  Let’s  assume  that  $500  million  of  the  $6.5  billion  in  this  asset  acquisiKon  has  already  been  spent  and  that  you  are  not  going  to  get  that  money  back.  Will  that  alter  your  decision?  

¤  If  yes,  why?  If  not,  why  not?  ¨  Or  allocated  expenses?  

¤  Let’s  also  assume  that  CRH  plans  to  allocate  $1  billion  in  G&A  costs  to  these  assets,  axer  it  acquires  them.  

¤  Will  that  change  your  assessment  of  the  investment?  If  yes,  why?  If  not,  why  not?  

49

Closure  on  Cash  Flows  

¨  In  a  project  with  a  finite  and  short  life,  you  would  need  to  compute  a  salvage  value,  which  is  the  expected  proceeds  from  selling  all  of  the  investment  in  the  project  at  the  end  of  the  project  life.  It  is  usually  set  equal  to  book  value  of  fixed  assets  and  working  capital    

¨  In  a  project  with  an  infinite  or  very  long  life,  we  compute  cash  flows  for  a  reasonable  period,  and  then  compute  a  terminal  value  for  this  project,  which  is  the  present  value  of  all  cash  flows  that  occur  axer  the  esKmaKon  period  ends..  

¨  Assuming  the  assets  that  CRH  acquires  will  last  well  past  year  10,  with  cash  flows  growing  at  0.2%  a  year  in  perpetuity,  the  value  of  the  assets  at  the  end  of  year  10  can  be  wriaen  as:  Terminal  Value  in  year  10=  CF  in  year  11/(Cost  of  Capital  -­‐  Growth  Rate)  

       =460  m  (1.002)  /(.0639-­‐.002)  =    7,451    m  

50

Which  yields  a  NPV  of..  

Discounted at the asset cost of capital of 6.39%

Year   Incremental  Cash  flow   Terminal  Value   PV  @  6.39%  

1    €  184.91          €  173.81    

2    €  192.04          €  169.67    

3    €  230.75          €  191.63    

4    €  274.43          €  214.23    

5    €  323.63          €  237.46    

6    €  378.55          €  261.08    

7    €  397.47          €  257.67    

8    €  417.35          €  254.31    

9    €  438.21          €  250.99    

10    €  460.13      €  7,450.86      €  4,259.04    

 €  6,269.88    

Cost  of  acquiring  assets      €  6,500.00    

Net  Present  Value  =   -­‐€  230.12    

51

First  Principles  

52

Debt:  Summarizing  the  trade  off  

53

Mechanics  of  Cost  of  Capital  EsKmaKon  

1.  EsKmate  the  Cost  of  Equity  at  different  levels  of  debt:    Equity  will  become  riskier  -­‐>  Beta  will  increase  -­‐>  Cost  of  Equity  will  increase.  EsKmaKon  will  use  levered  beta  calculaKon  

2.  EsKmate  the  Cost  of  Debt  at  different  levels  of  debt:    Default  risk  will  go  up  and  bond  raKngs  will  go  down  as  debt  goes  up  -­‐>  Cost  of  Debt  will  increase.  To  esKmaKng  bond  raKngs,  we  will  use  the  interest  coverage  raKo  (EBIT/Interest  expense)  

3.  EsKmate  the  Cost  of  Capital  at  different  levels  of  debt  4.  Calculate  the  effect  on  Firm  Value  and  Stock  Price.  

54

Finding  an  opKmal  mix:  CRH’s  cost  of  capital  schedule…  

Debt Ratio BetaCost of Equity

Bond Rating

Interest rate on debt Tax Rate

Cost of Debt (after-tax)

Cost of capital

0% 0.8774 5.72% Aaa/AAA 1.41% 30.00% 0.99% 5.72%10% 0.9456 6.15% Aaa/AAA 1.41% 30.00% 0.99% 5.63%20% 1.0309 6.68% Aa2/AA 1.71% 30.00% 1.20% 5.59%30% 1.1406 7.37% Caa/CCC 8.01% 30.00% 5.61% 6.84%40% 1.3399 8.62% Ca2/CC 9.01% 20.92% 7.13% 8.03%50% 1.6346 10.48% C2/C 11.01% 13.69% 9.50% 9.99%60% 2.0432 13.04% C2/C 11.01% 11.41% 9.75% 11.07%70% 2.7243 17.32% C2/C 11.01% 9.78% 9.93% 12.15%80% 4.0865 25.87% C2/C 11.01% 8.56% 10.07% 13.23%90% 8.1730 51.54% C2/C 11.01% 7.61% 10.17% 14.31%

55

A  Framework  for  Ge�ng  to  the  OpKmal  

Is the actual debt ratio greater than or lesser than the optimal debt ratio?

Actual > OptimalOverlevered

Actual < OptimalUnderlevered

Is the firm under bankruptcy threat? Is the firm a takeover target?

Yes No

Reduce Debt quickly1. Equity for Debt swap2. Sell Assets; use cashto pay off debt3. Renegotiate with lenders

Does the firm have good projects?ROE > Cost of EquityROC > Cost of Capital

YesTake good projects withnew equity or with retainedearnings.

No1. Pay off debt with retainedearnings.2. Reduce or eliminate dividends.3. Issue new equity and pay off debt.

Yes No

Does the firm have good projects?ROE > Cost of EquityROC > Cost of Capital

YesTake good projects withdebt.

No

Do your stockholders likedividends?

YesPay Dividends No

Buy back stock

Increase leveragequickly1. Debt/Equity swaps2. Borrow money&buy shares.

56

CRH:  Applying  the  Framework  

Is the actual debt ratio greater than or lesser than the optimal debt ratio?

Actual > OptimalSlightly overlevered

Actual < Optimal

Is the firm under bankruptcy threat? Is the firm a takeover target?

Yes No

Reduce Debt quickly1. Equity for Debt swap2. Sell Assets; use cashto pay off debt3. Renegotiate with lenders

Does the firm have good projects?ROE > Cost of EquityROC > Cost of Capital

Barely breaking even. Be opportunisitic, but tilt funding towards equity.

No1. Pay off debt with retainedearnings.2. Reduce or eliminate dividends.3. Issue new equity and pay off debt.

Yes No.

Does the firm have good projects?ROE > Cost of EquityROC > Cost of Capital

Yes. No

Do your stockholders likedividends?

YesPay Dividends No

Buy back stock

Increase leveragequickly1. Debt/Equity swaps2. Borrow money&buy shares.

57

Designing  Debt:  The  Fundamental  Principle  

¨  The  objecKve  in  designing  debt  is  to  make  the  cash  flows  on  debt  match  up  as  closely  as  possible  with  the  cash  flows  that  the  firm  makes  on  its  assets.  

¨  By  doing  so,  we  reduce  our  risk  of  default,  increase  debt  capacity  and  increase  firm  value.  

Firm Value

Value of Debt

Firm Value

Value of Debt

Unmatched DebtMatched Debt

58

Designing  Debt:  Bringing  it  all  together  

Duration Currency Effect of InflationUncertainty about Future

Growth Patterns Cyclicality &Other Effects

Define DebtCharacteristicsDuration/Maturity

CurrencyMix

Fixed vs. Floating Rate* More floating rate - if CF move with inflation- with greater uncertainty on future

Straight versusConvertible- Convertible ifcash flows low now but highexp. growth

Special Featureson Debt- Options to make cash flows on debt match cash flows on assets

Start with the Cash Flowson Assets/Projects

Overlay taxpreferencesDeductibility of cash flowsfor tax purposes

Differences in tax ratesacross different locales

Consider ratings agency& analyst concernsAnalyst Concerns- Effect on EPS- Value relative to comparables

Ratings Agency- Effect on Ratios- Ratios relative to comparables

Regulatory Concerns- Measures used

Factor in agencyconflicts between stockand bond holders

Observability of Cash Flowsby Lenders- Less observable cash flows lead to more conflicts

Type of Assets financed- Tangible and liquid assets create less agency problems

Existing Debt covenants- Restrictions on Financing

Consider Information Asymmetries Uncertainty about Future Cashflows- When there is more uncertainty, itmay be better to use short term debt

Credibility & Quality of the Firm- Firms with credibility problemswill issue more short term debt

If agency problems are substantial, consider issuing convertible bonds

Can securities be designed that can make these different entities happy?

If tax advantages are large enough, you might override results of previous step

Zero Coupons

Operating LeasesMIPsSurplus Notes

ConvertibilesPuttable BondsRating Sensitive

NotesLYONs

Commodity BondsCatastrophe Notes

Design debt to have cash flows that match up to cash flows on the assets financed

59

Designing  CRH’s  debt  

¨  What  is  the  duraKon  of  a  typical  project  for  CRH?  ¤  Very  short  term  (<  1  year)  ¤  Short  term  (1-­‐3  years)  ¤  Medium  term  (3-­‐5  years)  ¤  Long  term  

¨  What  currency  are  your  cash  flows  in?  ¨  How  much  pricing  power  do  you  have  (to  deal  with  changes  

in  inflaKon)?  ¤  None.  We  are  price  takers  ¤  Some.  We  are  the  third  largest  building  products  company  ¤  A  great  deal.  

¨  What  macro-­‐economic  variables  most  affect  your  cash  flows?  

60

Analyzing  CRH’s  Current  Debt  

61

First  Principles  

62

Assessing  Dividend  Policy  

¨  Step  1:  How  much  could  the  company  have  paid  out  during  the  period  under  quesKon?  

¨  Step  2:  How    much  did  the  the  company  actually  pay  out  during  the  period  in  quesKon?  

¨  Step  3:  How  much  do  I  trust  the  management  of  this  company  with  excess  cash?  ¤ How  well  did  they  make  investments  during  the  period  in  quesKon?  

¤ How  well  has  my  stock  performed  during  the  period  in  quesKon?  

63

How  much  has  the  company  returned  to  stockholders?  

¨  As  firms  increasing  use  stock  buybacks,  we  have  to  measure  cash  returned  to  stockholders  as  not  only  dividends  but  also  buybacks.  

¨  For  instance,  for  CRH,  we  obtain  the  following:  

    2010   2011   2012   2013   2014  

Dividends   $298.00     $310.00     $362.00     $367.00     $353.00    

 +  Stock  Buybacks   $0.00     $0.00     $0.00     $0.00     $0.00    

 =  Cash  to  Stockholders   $298.00     $310.00     $362.00     $367.00     $353.00    

64

A  Measure  of  How  Much  a  Company  Could  have  Afforded  to  Pay  out:  FCFE  

¨  The  Free  Cashflow  to  Equity  (FCFE)  is  a  measure  of  how  much  cash  is  lex  in  the  business  axer  non-­‐equity  claimholders  (debt  and  preferred  stock)  have  been  paid,  and  axer  any  reinvestment  needed  to  sustain  the  firm’s  assets  and  future  growth.  Net  Income  

 +  DepreciaKon  &  AmorKzaKon        =  Cash  flows  from  OperaKons  to  Equity  Investors    -­‐  Preferred  Dividends    -­‐  Capital  Expenditures      -­‐  Working  Capital  Needs    -­‐  Principal  Repayments    +  Proceeds  from  New  Debt  Issues        =  Free  Cash  flow  to  Equity  

65

CRH’s  FCFE  

  2010 2011 2012 2013 2014

Net Income $432.00 $590.00 $538.00 ($296.00) $582.00

- (Cap. Exp - Depr) ($452.00) ($209.00) ($186.00) ($228.00) ($240.00)

- ∂ Working Capital ($142.00) $211.00 $58.00 ($77.00) ($35.00)

Free CF to Equity (pre-debt) $1,026.00 $588.00 $666.00 $9.00 $857.00

+ Net Debt Issued $566.00 $101.00 $487.00 $1,491.00 $901.00

= Free CF to Equity (actual debt) $1,592.00 $689.00 $1,153.00 $1,500.00 $1,758.00 Free CF to Equity (target debt ratio) $887.18 $588.47 $636.09 ($62.28) $792.73

66

CRH:  Cash  Returned  vs  FCFE  

    2010   2011   2012   2013   2014  

FCFE   $887.18     $588.47     $636.09     ($62.28)   $792.73    

Dividends  +  Buybacks   $298.00   $310.00   $362.00   $367.00   $353.00  

2010   2011   2012   2013   2014  

Cash  Retained   $589.18   $867.65   $1,141.74   $712.46   $1,152.19  

67

A  PracKcal  Framework  for  Analyzing  Dividend  Policy  

How much did the firm pay out? How much could it have afforded to pay out?What it could have paid out What it actually paid outNet Income Dividends- (Cap Ex - Depr’n) (1-DR) + Equity Repurchase- Chg Working Capital (1-DR)= FCFE

Firm pays out too littleFCFE > Dividends Firm pays out too much

FCFE < Dividends

Do you trust managers in the company withyour cash?Look at past project choice:Compare ROE to Cost of Equity

ROC to WACC

What investment opportunities does the firm have?Look at past project choice:Compare ROE to Cost of Equity

ROC to WACC

Firm has history of good project choice and good projects in the future

Firm has historyof poor project choice

Firm has good projects

Firm has poor projects

Give managers the flexibility to keep cash and set dividends

Force managers to justify holding cash or return cash to stockholders

Firm should cut dividends and reinvest more

Firm should deal with its investment problem first and then cut dividends

68

Can  investors  trust  CRH’s  management?  

¨  Given  CRH’s  track  record,  if  you  were  a  CRH  stockholder,  would  you  be  comfortable  with  CRH’s  dividend  policy?  ¨  Yes  ¨  No  

¨  CRH  clearly  has  used  the  cash  built  up  over  the  last  few  years  to  acquire  assets  in  the  Lafarge/Holcim  merger?  What  are  the  implicaKons  for  dividend  policy  in  the  future?  

69

First  Principles  

70

The  Ingredients  that  determine  value.  

Terminal yearEBIT (1-t) 1504- Reinv 53FCFF 1451

Terminal Value10= 1451/(.06-.0021) = 25068

Cost of capital = 6.89% (.768) + 1.37% (.232) = 5.60%

Beta 1.06

Operating assets 18,966+ Cash 3,262+ Cross holdings 1,329- Debt 5,866- Min Interest 21- Mgt Options 169Value of equity 17,501Value/share 23.63

WeightsE = 76.8% D = 23.2%

Cost of Debt (Rating: Baa2)(0.21%+1.75%)(1-.30)= 1.37%

Cost of Equity6.89%

Stable Growthg = 0.21%;

Cost of capital = 6% ROC= 6%;

Reinvestment Rate=.2%/6% = 3.33%

Riskfree Rate:Riskfree rate = 0.21% + X

In March 2015, CRH was trading at 27.79 Euros per share.

Cost of capital decreases to 6.65% from years 6-10

D/E 30.27%

CRH: My valuation (March 2015)

Revenue growth of 5% a year for

5 years, tapering down to

0.21% in year 10

Pre-tax operating

margin increases to 8%

over time.

Sales to capital ratio of

1.48 for incremental

sales

Business Proportion Unlevered0BetaConstruction*Supplies 49.21% 0.8934Building*Materials 18.35% 0.7998Retail*(Building*Supply) 32.43% 0.8970CRH*(Company) 0.8774

Region Proportion ERPNorth&America 53.17% 5.75%Western&Europe 46.83% 6.88%CRH 100.00% 6.28%

CompanyIndustry (US)

Industry (Global)

Revenue growth last year = 4.89% 8.98% 7.27%Pre-tax operating margin 5.11% 10.03% 7.82%Sales to capital ratio = 1.48 1.48 1.20ROIC in most recent year 5.85% 12.42% 7.93%

1 2 3 4 5 6 7 8 9 10Revenue growth rate 5.00% 5.00% 5.00% 5.00% 5.00% 4.04% 3.08% 2.13% 1.17% 0.21%Revenues € 19,858 € 20,850 € 21,893 € 22,988 € 24,137 € 25,113 € 25,887 € 26,437 € 26,746 € 26,802EBIT (Operating) margin 5.40% 5.69% 5.98% 6.26% 6.55% 6.84% 7.13% 7.42% 7.71% 8.00%EBIT (Operating income) € 1,072 € 1,186 € 1,308 € 1,440 € 1,582 € 1,718 € 1,846 € 1,962 € 2,062 € 2,144Tax rate 23.14% 23.14% 23.14% 23.14% 23.14% 24.51% 25.88% 27.26% 28.63% 30.00%EBIT(1-t) € 824 € 911 € 1,005 € 1,107 € 1,216 € 1,297 € 1,368 € 1,427 € 1,472 € 1,501 - Reinvestment € 639 € 671 € 704 € 740 € 777 € 659 € 523 € 372 € 209 € 38FCFF € 185 € 240 € 301 € 367 € 439 € 638 € 845 € 1,055 € 1,263 € 1,463

72

Ways  of  changing  value…  

Cashflows from existing assetsCashflows before debt payments, but after taxes and reinvestment to maintain exising assets

Expected Growth during high growth period

Growth from new investmentsGrowth created by making new investments; function of amount and quality of investments

Efficiency GrowthGrowth generated by using existing assets better

Length of the high growth periodSince value creating growth requires excess returns, this is a function of- Magnitude of competitive advantages- Sustainability of competitive advantages

Stable growth firm, with no or very limited excess returns

Cost of capital to apply to discounting cashflowsDetermined by- Operating risk of the company- Default risk of the company- Mix of debt and equity used in financing

How well do you manage your existing investments/assets?

Are you investing optimally forfuture growth? Is there scope for more

efficient utilization of exsting assets?

Are you building on your competitive advantages?

Are you using the right amount and kind of debt for your firm?

73

Value Creation 1: Increase Cash Flows from Assets in Place

Revenues

* Operating Margin

= EBIT

- Tax Rate * EBIT

= EBIT (1-t)

+ Depreciation- Capital Expenditures- Chg in Working Capital= FCFF

Divest assets thathave negative EBIT

More efficient operations and cost cuttting: Higher Margins

Reduce tax rate- moving income to lower tax locales- transfer pricing- risk management

Live off past over- investment

Better inventory management and tighter credit policies

74

Value Creation 2: Increase Expected Growth

¨  Keeping all else constant, increasing the expected growth in earnings will increase the value of a firm.

¨  The expected growth in earnings of any firm is a function of two variables:¤  The amount that the firm reinvests in assets and projects¤  The quality of these investments

Reinvestment Rate

* Return on Capital

= Expected Growth Rate

Reinvest more inprojects

Do acquisitions

Increase operatingmargins

Increase capital turnover ratio

Price Leader versus Volume Leader StrategiesReturn on Capital = Operating Margin * Capital Turnover Ratio

75

A postscript on creating growth: The Role of Acquisitions and Divestitures¨  An acquisition is just a large-scale project. All of the rules that

apply to individual investments apply to acquisitions, as well. For an acquisition to create value, it has to¤  Generate a higher return on capital, after allowing for synergy and

control factors, than the cost of capital. ¤  Put another way, an acquisition will create value only if the present

value of the cash flows on the acquired firm, inclusive of synergy and control benefits, exceeds the cost of the acquisitons

¨  A divestiture is the reverse of an acquisition, with a cash inflow now (from divesting the assets) followed by cash outflows (i.e., cash flows foregone on the divested asset) in the future. If the present value of the future cash outflows is less than the cash inflow today, the divestiture will increase value.

¨  A fair-price acquisition or divestiture is value neutral.

76

Value Creating Growth… Evaluating the Alternatives..

77

A more general problem… Growing through acquisitions has never been easy…¨  Firms that grow through acquisitions have generally had far

more trouble creating value than firms that grow through internal investments.

¨  In general, acquiring firms tend to¤  Pay too much for target firms¤  Over estimate the value of “synergy” and “control”¤  Have a difficult time delivering the promised benefits

¨  Worse still, there seems to be very little learning built into the process. The same mistakes are made over and over again, often by the same firms with the same advisors.

¨  Conclusion: There is something structurally wrong with the process for acquisitions which is feeding into the mistakes.

78

Seven reasons why acquisitions fail…

1.  Risk Transference: Attributing acquiring company risk characteristics to the target firm. Just because you are a safe firm and operate in a secure market, does not mean that you can transfer these characteristics to a target firm.

2.  Debt subsidies: Subsiding target firm stockholders for the strengths of the acquiring firm is providing them with a benefit they did not earn.

3.  Auto-pilot Control: Adding 20% or some arbitrary number to the market price just because other people do it is a recipe for overpayment. Using silly rules such as EPS accretion just makes the problem worse.

4.  Elusive Synergy: While there is much talk about synergy in mergers, it is seldom valued realistically or appropriately.

5.  Its all relative: The use of transaction multiples (multiples paid by other acquirers in acquisitions) perpetuates over payment.

6.  Verdict first, trial afterwards: Deciding you want to do an acquisition first and then looking for justification for the price paid does not make sense.

7.  It’s not my fault: Holding no one responsible for delivering results is a sure-fire way not to get results…

79

III. Building Competitive Advantages: Increase length of the growth period

Increase length of growth period

Build on existing competitive advantages

Find new competitive advantages

Brand name

Legal Protection

Switching Costs

Cost advantages

80

Value Creation 4: Reduce Cost of Capital

Cost of Equity (E/(D+E) + Pre-tax Cost of Debt (D./(D+E)) = Cost of Capital

Change financing mix

Make product or service less discretionary to customers

Reduce operating leverage

Match debt to assets, reducing default risk

Changing product characteristics

More effective advertising

Outsourcing Flexible wage contracts &cost structure

Swaps Derivatives Hybrids

81

CRH:  Growth  through  investments  

¨  Of  the  opKons  available  to  increase  CRH’s  value  per  share,  which  of  the  following  offers  the  most  promise?  a.  Efficiency  growth:  Increase  margins  on  exisKng  

investments.  b.  Invest  in  exisKng  markets  in  Europe  and  North  America,  

going  for  higher  market  share.  c.  Expand  into  new  markets:  Invest  in  emerging  markets  

(either  as  projects  or  by  acquiring  companies).  d.  Expand  into  new  businesses:  Enter  new  businesses,  

perhaps  in  the  construcKon/building  sphere.  

82

CRH:  Financial  Engineering?  

¨  If  you  see  potenKal  value  creaKon  for  CRH  in  capital  structure,  which  of  the  following  do  you  see  as  your  best  opKon?  ¤  Change  the  debt  raKo  (either  increase  or  decrease  it)  ¤  Change  the  maturity  of  the  debt  (longer  term  or  shorter  term)  

¤  Change  the  types  of  debt  (more  floaKng  rate?  More  converKble)  

 

83

CRH:  Dividend  PotenKal  

¨  If  you  are  trying  to  increase  CRH’s  value  to  equity  investors  and  are  looking  at  dividend  policy,  which  of  the  following  offers  the  best  potenKal?  

a.  Increase  dividends  paid  to  stockholders  b.  Hold  dividends  stable  and  increase  stock  buybacks  c.  Decrease  dividends  paid  to  stockholders  d.  Don’t  return  cash  

84

Value  Effects  

Compounded revenue growth rate: Next 5 years

1.00% 3.00% 5.00% 7.00% 9.00%

Targ

et O

pera

ting

Mar

gin

4.00% € 11.18 € 10.70 € 10.16 € 9.55 € 8.87

5.11% (Current) € 14.06 € 13.98 € 13.89 € 13.79 € 13.67

6.00% € 16.38 € 16.62 € 16.89 € 17.19 € 17.53

8.00% € 21.58 € 22.55 € 23.63 € 24.83 € 26.18

10.00% € 26.78 € 28.47 € 30.36 € 32.47 € 34.83

12.00% € 31.99 € 34.39 € 37.09 € 40.11 € 43.49

85

You  can  always  play  the  pricing  game..  

Aswath Damodaran

85

The  market  gives…   And  takes  away….  

86

First  Principles